This is my 5th article on commercial loan underwriting and cap rates. Cap rates are an extremely important concept in commercial real estate finance, so if you first want to catch up by reading my first four articles, here they are:
- Cap Rates and Commercial Loans I
- Cap Rates and Commercial Loans II
- Commercial Loans, Cap Rates, and Commercial Loan Constants
- Commercial Loans and Valuing a Commercial Property Using a Cap Rate
But don't panic. You don't need to read the prior articles to understand's today's lesson. The odd lesson that I hope you will learn from today's article is that commercial loans on butt-ugly properties in gang warfare zones actually cash flow better than commercial loans made on gorgeous properties in prime areas.
Real estate investors buy commercial properties because such properties generate cash flow (net rental income). You will recall that we said that a Cap Rate is simply the return on your purchase price that you would earn if you bought an income property for all cash.
For example, if you paid $1 million in cash for an average office building in an average area and enjoyed $80,000 per year in net rental income from the investment, you have bought the property at an 8% cap rate.
Cap Rate = (Net Operating Income / Purchase Price) x 100%
Cap Rate = ($80,000 / $1,000,000) x 100%
Cap Rate = .08 x 100%
Cap Rate = 8.0%
Suppose I told you that you could buy a competing building and earn $85,000 per year in net rental income (net operating income). Would you do it? Of course! That's an extra $5,000 per year. You could buy season tickets to the San Francisco Giants.
But wait a minute. What if I told you that, in order to collect your rent, you would have to drive every month into some gang-infested, war zone with contaminated heroin needles lying everywhere. Yuck. No thank you!
Hold on a second. What if I made it $90,000 per year in net operating income (a 9% cap rate)? That's an extra $10,000 per year in income. No? How about if the property generated a net operating income of $100,000 (a 10% cap rate)? You're still shaking your head. Apparently you don't like risking your life twelve times a year to collect your rent.
Okay, here's my final offer: You can buy this competing income-generating building in the ghetto at a whooping 12% cap rate. In other words, if you invest $1 million in this building, it will throw off $120,000 in cash flow (net operating income). That's an extra $40,000 per year.
Hmmmm. You could be careful to only visit the ghetto property on sunny days in the morning. You could hide a gun in your car. You could run in, collect the rents, run out, and drive quickly away, like a bank robber. Okay, you'll buy this building at a 12% cap rate.
So lesson number one: When you are underwriting a commercial loan, the higher the cap rate, the yuckier the property and/or its location.
Now let's suppose that you decided not use all of your available cash to buy this new income property. Instead, you decide to put just 25% down ($250,000) and finance the rest with the bank.
Will your commercial loan qualify? Just for fun, let's look at both buildings, the average office building in an average area selling at an 8% cap rate and the ugly industrial building in the ghetto selling at a 12% cap rate. Let's also assume that the bank is making conventional commercial loans today (let's assume the year is 2016 and interest rates are higher) at 7.25%, amortized over 25 years.
The Debt Service Coverage Ratio (DSCR) is defined as Net Operating Income (NOI) divided by the Annual Debt Service (just a fancy word for annual loan payments).
DSCR = NOI / Annual Debt Service
This number usually must equal or exceed 1.25.
Let's look at the average office building first. The Annual Debt Service on a $750,000 loan at 7.25%, amortized over 25 years (the typical amortization period for a conventional commercial loan from a bank) is $65,052. Therefore -
DSCR = $80,000* / $65,052
DSCR = 1.23 (The property doesn't qualify!)
* Remember, a cap rate of 8% means that if you buy the $1,000,000 commercial property for all cash, you will enjoy a Net Operating Income (think of it as the "interest" on your investment) of $80,000.
Please note that because the Debt Service Coverage is only 1.23 - less than the required 1.25 DSCR - this average-quality office building in an average area does not qualify for the full $750,000 loan. Hmmm ...
Now let's look at the industrial property in the ghetto. We said you could buy this $1 million property at a 12% cap rate. A 12% cap rate means that you would enjoy a whopping $120,000 in Net Operating Income (net rental income). Once again, think of this 12% return as if it was the "interest" on your investment.
Now before we compute the debt service coverage ratio of a $750,000 loan on this ugly industrial building in the ghetto, there is one more little twist to consider.
When making commercial loans on ugly commercial properties or commercial loans in rough areas, commercial banks will usually cut the Amortization Term from 25 years to just 20 years. Therefore, for the purposes of computing the Debt Service Coverage Ratio (DSCR) on this ugly industrial building in the ghetto, we will use a 7.25%, TWENTY-year loan constant.
Okay, we are now ready to compute the Debt Service Coverage Ratio (DSCR) on a $750,000 commercial loan - using a 7.25%, 20-year loan constant - on our ugly industrial building in the ghetto.
DSCR = NOI / Annual Debt Service
DSCR = $120,000 / $71,134
DSCR = 1.69 (The deal qualifies and really cash flows nicely!)
Hmmm ... this is interesting. The commercial loan on the butt-ugly industrial building in the ghetto actually cash flows much better than the commercial loan on the average-quality office building in the average area. Who would have 'thunk it?
So this is the lesson for today. While commercial properties that sell at higher cap rates are usually uglier and/or have inferior locations to those that sell at lower cap rates, they actually cash flow much better.
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